Public and private investments in anything, including commercial real estate, have significant differences. The main one is serial correlation in private markets, which is largely missing in public ones. Not accounting for that difference can result in masked risk in private CRE equity. That can result in overallocation to CRE equity, according to CBRE.
Public markets tend to be relatively transparent and liquid. There is constant available activity that makes them efficient at distributing news. As a result, “prices fluctuate as if they are random,” although they aren’t. That is an illusion. Public markets are forward-looking and there is causality.
Private markets, on the other hand, don’t have constant public updates. They are “illiquid and transaction costs are higher.” Instead, they look at methods like appraisals and transaction histories which create lagged reactions and, as a result, serial correlation. It essentially becomes a smoothing function that lets past returns partly predict future returns.
The difference between the two makes it challenging to compare risk-return performance, like with REITs with property or trying to determine the best asset allocations in a broad portfolio that includes equities, bonds, property, and mortgages. This is where the risk masking comes in. The serial correlation can leave investors assuming they can better predict the future and assume that private property is less risky than other investment types.
CBRE said that correcting the serial correlation shows the true property return volatility to be similar to that of public equity REITs. “We compare past and current total quarterly returns of traded public shares—S&P 500 and all equity REITs—with unleveraged and leveraged property (the NCREIF all-property leveraged index),” they wrote.
Past S&P 500 returns don’t predict current returns. The same is true for past REIT returns not predicting current ones. However, past property returns show a tight linear pattern.
Then CBRE looked at the relationship between property returns and NOI growth. There is a “statistically significant but complex relationship” between property returns and NOI growth. But NOI growth only explains about 6.4% of return variation. In its property model, CBRE included additional factors such as lagged REIT returns, DMBS returns, NOI growth, and lagged property returns, and saw the R correlation test increase from 6.4% to 83.9%.
